BANK OF AMERICA: Here's how to protect yourself from getting blindsided by the outcome of Trump's trade war that many aren't prepared for
- The US and China this week escalated their trade dispute that has sent investors fleeing from risky emerging-market assets.
- According to Bank of America Merrill Lynch's cross-asset strategists, investors are only positioned for one outcome of the trade war.
- They outlined why investor fears may be overblown, and a few of their hedges in case the dispute worsens.
The trade war between the US and China is escalating, but many investors may be caught off guard by one of the possible outcomes, according to Bank of America Merrill Lynch.
President Donald Trump upped the ante on Monday when he instructed the US Trade Representative to impose a tariff on $200 billion worth of Chinese goods. The latest tariffs, along with previous rounds on $50 billion of imports, meant that over half of all Chinese goods coming into the US would be subject to the duties.
China hit back the following day, announcing tariffs on $60 billion worth of US goods.
Investors are disproportionately expecting the dispute to worsen, versus a trade deal that resolves the situation, according to James Barty, the head of global cross-asset and emerging-market strategy at Bank of America Merill Lynch.
There's proof of this bias in how much better US risk assets are performing versus emerging markets. In a recent note, Barty pointed out that non-US equities were underperforming US stocks by the most since the financial crisis.
Sure, some of the weakness in emerging markets has stemmed from country-specific issues like the currency crisis in Turkey. Some of it also has to do with rising US interest rates, a stronger dollar, and a firm economy that's supporting earnings growth.
However, the initial rally of Asian and emerging-market stocks after Trump escalated the trade war on Monday demonstrated how much of the news had already been priced in, Barty said.
Meanwhile, Larry Kudlow, Trump's top economic adviser, has said "the door is open" for talks with China. And with the Trump administration eyeing the midterm elections and a second presidential term, it may not want to disrupt the economy's progress.
"This leaves investors in a quandary because should there be talks and a turnaround leading to a trade deal (as in NAFTA, EU/US) then with the Chinese already stimulating their economy and the US continuing to grow rapidly the prospects for a decent year of growth in 2019 would look pretty good," Barty said in a client note on Friday.
"In that situation, given where sentiment and positioning are, you could see a big rally in EM and cyclical assets."
Such a rally would challenge the majority view, according to Bank of America's survey of fund managers, that emerging-market risk is higher than normal.
These investors are putting their money where their mouth is. The chart below shows that compared to other major asset groups, fund managers have the smallest positions in emerging markets relative to history.
Barty is not oblivious to why investors are cautious and to the damage a "full-blown" trade war would do. A Chinese economic slowdown - or even just fears of one - could spook global risk assets, as happened early in 2016. Also, the Federal Reserve has flagged the downside risks of a trade war and could focus on them more if tariffs intensify.
Barty's team added to its EM positions over the summer, but also maintained hedges just in case.
"We feel we cannot own risk without protection given the trade tensions," Barty said. "Accordingly we continue to run put spreads in SPX, UKX and EEM. We also have an AUD/JPY put. We keep our long SX5E, NKY, RTY vs SPX var as non-US markets are more vulnerable to trade driven sell off."
The dispute is already widely being called a "trade war," which brings into question what Barty is referring to as a "full-blown" situation. According to Kate Warne, an investment strategist at Edward Jones, a trade war becomes full blown when each country's objective is not sending a signal or retaliation, but actually trying to restrict trade.
"For a trade war, you really need both sides saying 'what we want is higher tariffs and to stop this trade,' and that's when you get the escalation," Warne told Business Insider.
"That's where you get countries hurting themselves for the 'benefit' of less trade."